The Education of a Corporate Bond Manager, Part VII

Credit analysts are a corporate bond manager’s best friends.  No portfolio manager can be entirely aware of the extent of credit risks in a broad portfolio.  They provide a necessary check on the ability of the portfolio manager to play “cowboy” (or “cowgirl”), and to mix the metaphors, be a yield hog.

The native tendency of almost all bond portfolio managers, unless they have discipline, is to seek extra yield, for two reasons:

  • In the short run, on average, a portfolio with more yield earns more.
  • Many managers will conclude that a higher yielding credit will rally, due to mean-reversion.

The second observation is true about half the time in my opinion, but the rewards are asymmetric.  Gains are small, and losses are large.  It does not pay to be a yield hog.

I listened closely to my analysts.  After all, if you have talented analysts, why shouldn’t you listen to them aside from a misbegotten pride?  I always did what my analysts told me to do, but I did it on my timing, and I explained that to them: “I will sell this bond, but right now, the market is running hot, and marginal bonds like this one are in hot demand.  If I wait a week or two, I will get a better price.”

Communication is the key, as it is in any relationship.  More communication make the analyst feel valued.  Letting them know why you like or don’t like an idea of theirs is useful to them.  Giving them pricing data helps them grasp what you are up to, and can lead them to provide real help, once they grasp the problem.

But ignoring them, except to blame them when they make bad calls, leads to a poisonous relationship, and does not lead to stellar performance.  Don’t get me wrong, I think portfolio managers should lead, and credit analysts guide them, but if there isn’t respect for the analysts, you may as well give up.  They are professionals as well as you.

Now, the intelligent portfolio manager underwrites his analysts.  All analysts have biases.  Some will say “Yes” to almost everything, some will say “No” to almost everything, and some are balanced.  There are ways to break them out of their biases, though.  Giving them a list of spreads for the companies that they cover, and asking them to rank the credits in their sector is a good start.

For Mr. Yes, ask him about risk factors.  Ask him how it would rank relative to major competitors.  For Ms. No, ask her what are the best names she would invest in.  Where is there opportunity?  Ask her to rank the company versus major competitors.  It’s a challenge, but if your analysts are bright people, you can retrain them to think past their biases, and give you good information that you can apply to making buy and sell decisions.

If I may, this is another area where being polite, reasonable, and (dare I say) loving, pays off.  Showing care for you colleagues pays large dividends.  I am not saying be a pushover, but the more you cultivate your colleagues, the better results become.

Monoculture

Every investment shop tends to create  a sort of monoculture, modeled off the guy at the top.  Now, if the boss has succeeded for a long time, it is because his unique views have punch.  All the same, situations will come up where the firm is long a name to nearly the maximum level, and the credit analyst is certain of his opinion, though the price keeps falling.

What to do?  Here are the steps:

  • Have other analysts analyze it.  It may not be their sector, but they are professionals, and will bring a fresh set of eyes to the problem.  If that fails, then…
  • Have the portfolio managers take the name home and analyze it.  Let them poke holes in the thesis.  But if no one can find a hole…
  • Look at Street research, to find the bears… circulate the opinion to all on the team.  If the opinion makes sense at present pricing, sell out.  If it makes no sense, waive the credit limits and buy more.  Look for reasons as to why others might be forced sellers.

The idea is to challenge the internal credit culture of the firm, and analyze the market dynamics that might be creating a lower price in the short run than might exist in the long run.

That’s all for now, more to come in part eight.  Wait, how many parts will there be in this series?  The present target is twelve.